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Health Care Stocks to Watch in 2010

The health care reform overhang is ending, making 2010 a safer time for investors to look at health care names. But is it already too late to find attractive pricing among the sector's large-cap players?

NEW YORK ( TheStreet) -- With a small-cap rally leading 2009 equity gains, conventional market wisdom dictates that large-cap companies in the health care sector should receive more attention in 2010.

Resolution to health care reform sholud also bring back those jittery investors who have remained on the healthcare sidelines.

The big pharmaceutical players have also been trading at pretty big price-to-earnings discounts versus the broad market -- a discount of approximately 34% to the S&P 500, according to health care consultant Leerink Swann.

Research firms that are overweighing Pfizer, such as Leerink Swann, point to the "certainty of earnings" or "controlled earnings." Pfizer is still in the middle of its integration with Wyeth ( WYEPR).

Pfizer has its p/e discount argument, too -- trading at nine times 2010 earnings, compared with the broad market's 17.5 times earnings ratio. Pfizer has never been a p/e leader, but has typically traded closer to the broad market. Pfizer bulls like Leerink Swann's head of health care research John Sullivan, say that cost controls, coupled with the p/e discount, make Pfizer shares attractive even given concerns over its future drug pipeline.

Still, a second opinion is always a good idea when it comes to heath care. Avik Roy, an analyst with Monness, Crespi & Hardt, said the structural problems for large pharmaceuticals firms are at heart of why their p/e ratios have been lower, and those questions have not been answered. So don't expect a big p/e boost in 2010, Roy argues.

"Pfizer can only move when all the big institutions bet on it, and that's driven by quality of pipeline relative to patent expirations," Roy explained. With powerhouse drug Lipitor going off patent, it is not clear what will drive future growth. Does cost-cutting post-merger lead to top line quality growth? Roy doesn't think so. "Certainty of earnings is fine, but the market won't reward cost-driven earnings with monster multiples; that's a dividend yield, deep-value play," Roy argues.

The most important question, then, may be this: While there could be little downside risk to Pfizer given its current valuation, is there much upside potential?

Is the Merck scenario any healthier?

Many health care experts argue that if an investor wants to get healthy gains with big pharma in 2010, Merck ( MRK ) is the more potent story.

Merck is also in the middle of merger integration, with Schering-Plough. The deal has received much more praise from the market than the Pfizer-Wyeth marriage. Still, how much better is Merck's positioning that Pfizer?

When it comes down to the all-important future pipeline question, Merck's research and development is considered meaningfully greater than the pipeline at Pfizer. "You expect 90% of R&D efforts to fail, not 100%," said Les Funtleyder, an analyst with Miller Tabak, when comparing Merck to Pfizer.

Merck and Schering also have a far better history than Pfizer of developing new compounds. And Funtleyder noted that patent-expiring Lipitor papered over a lot of R&D failures for Pfizer. Merck bought time to develop its pipeline with the deal, and in the most bullish scenario for its drug pipeline, Merck will be the big pharma stock that could switch from a defensive play to a growth company.

If you're still a bear on economic recovery, healthcare stocks like the big pharmaceuticals often make good defensive bets. Still, analysts caution investors who are looking for big growth stories from pharmaceuticals in 2010 to steer clear of the Superbowl-advertising drug stocks, and look to the biotechnology sector.

Managed care stocks have experienced quite the run-up as a resolution in healthcare reform has become more visible.

There was no health care sub-sector in which the reform overhang was more damaging to stock performance than managed care. Even today, managed-care stocks are still trading at approximately two-thirds of the broad market p/e ratio, demonstrating the ongoing skepticism of how well managed-care stocks can perform post-reform.

Cigna ( CI) has led the way in the recovery of managed-care stocks. Is the run done?

The 2010 story for Cigna and the managed care universe is, first and foremost, that the reform overhang will be gone and it will be a year of transition. Curbs on business will be significant: excise taxes, lifetime caps on benefits, and the inability to exclude pre-existing conditions, among them. Costs associated with these changes may not be passed on to customers until after 2010.

The market perception is that Cigna's tilt to the commercial business (80% of which is self-insured and not subject to adverse impact from higher COBRA enrollment), and its 40% ex-U.S. business stream, will insulate it from many of the reform package cost targets. Still, some analysts point out that many of those Medicare cuts aren't going to kick in immediately in 2010 -- maybe not until 2014 -- making it hard to see much more room for movement up in Cigna shares in the short-term.

WellPoint ( WLP), right alongside Cigna, has benefited more than the managed care peer group from the recent rally.

The managed care sector as a whole rebounded from a p/e level that was 40% of the broad market early in 2009, to 60% of the market more recently. Monness Crespi's Avik Roy thinks that once the public option died, WellPoint and Cigna received price bumps from an excessively discounted risk level.

WellPoint has also benefited from three consecutive quarters of improved earnings per share and net income. WellPoint also completed the sale of its pharmacy benefits business earlier this month, and Leerink Swann's Sullivan believes that sets the stage for share repurchase activity in 2010.

Leerink Swank has a 12-month valuation target of $58-$65 on WellPoint. WellPoint shares are currently near $59, with a 52-week high of just under $61.

So while there is little doubt that WellPoint and Cigna are well-positioned long-term to deal with the health care reform challenges, that might not necessarily make WellPoint or Cigna the best play in 2010."There is already a fair amount priced into WellPoint and Cigna," said Monness Crespi's Roy.

While many analysts think the managed care rally will continue into the first half of 2010, will underperforming stocks like UnitedHealth Group ( UNH) be the big gainers? United is the most well-known example of a managed-care stock with a significant Medicare Advantage-laden business.

Still, United has its bulls, given its underperformance. Miller Tabak's Funtleyder says that UnitedHealth is more diversified than the market's perception would lead an investor to think, and its commercial business should rebound along with an improvement in the economy. "We love United because it has not had the run-up of Cigna or WellPoint," Funtleyder says.

What's more, medical technology stocks like Medtronic ( MDT), Boston Scientific ( BSX) and St. Jude Medical ( STJ) can expect to receive a boost from favorable currency winds and continued weakness in the U.S. Dollar.

On a company-to-company basis, though, Medtronic has outperformed its peers in recent months, and Boston Scientific is the sector turnaround story on which all eyes are focused.

Boston Scientific is still implementing plans from its new management team, and that has the potential to generate earnings power in the short-term that will outdistance Medtronic, which has already rallied on recent outperformance. "We will see the benefits in Boston Scientific results over the next several quarters," says Leerink Swann's Sullivan.

Some analysts concede that Boston Scientific is poised for a turnaround -- new CEO Ray Elliott has been on the job for only six months and has overseen previous health care comebacks like Zimmer Holdings ( ZMH). Still, they question the timing and extent of a positive move from Boston Scientific.

"Even if all Boston Scientific does is engineer a minor turnaround, the market will look at it very positively," said Miller Tabak's Funtleyder. "Because it was so weak in the past, it is quite possible that by default, with a new management team, Boston Scientific will show improvement," the Miller Tabak analyst argues.

Monness Crespi's Roy agrees, saying that from a stock performance standpoint, Boston Scientific is appealing, but it does come down to a belief that a turnaround is imminent, and with that belief Roy has his reservations.

Boston Scientific's price-to-earnings ratio is already slightly above the average in its peer group. Still, BSX bulls like Leerink Swann are projecting an increase from 14.6 times earnings times 2010 estimated earnings per share of $0.60, to 16 times a 2011 estimated earnings per share of $0.76. Leerink is projecting a Boston Scientific 12-month stock rise to $12, up from its current $9 level. Boston Scientific's 52-week high was attained at the end of the summer, before its disappointing third-quarter earnings.

One health care sub-sector that experienced no major reform overhang is information technology. The move to electronic records for hospitals and physician practices was never in doubt.

The fact that the movement to electronic records is coming without a doubt has made large-cap names like Cerner ( CERN) very popular; Cerner has been trading in the range of its 52-week high of $85.97 since mid-October.

The information technology health care stocks, including Cerner, AthenaHealth ( ATHN) and Allscripts-Misys Healthcare Solutions ( MDRX) have all experienced a big rally over the second half of 2009. Decent earnings have helped push shares higher, but the potential for government incentives to hospital and physician practice customers of these IT firms for making the change to electronic records, is a bigger part of the upswing.

Some analysts think that potential has been overdone, at least in terms of a 2010 story. "Some time, we will have to see genuine evidence of the potential, and it's not like the government has opened up its checkbook yet," said Miller Tabak's Funtleyder. "For Cerner, it is put up or shut up time," Funtleyder added.

The Miller Tabak analyst believes that the recent earnings alone do not justify the run-up in these IT stocks, and the adoption rate for electronic records is still an unknown. "The massive demand will either show up, or it won't, but there is already a lot of optimism priced into these stocks. We take a wait and see approach, as opposed to chasing these names now," Funtleyder said.

Jamie Stockton, a health care analyst at Morgan Keegan, noted that there will be $45 billion in government incentives to hospitals and physician practices to make the change to electronic records between 2011 and 2016. While that will be a profit-driver for IT players like Cerner, the biggest demand period may not occur in 2010.

Morgan Keegan is forecasting 20%-30% of the demand to come in 2010, while the biggest portion of software sales to hospitals and physicians will occur in 2011, of approximately 40%. Many of these IT players, including Cerner, have had flat top-line growth in 2009. Growth should come in 2010 -- Morgan Keegan is targeting 15% for Cerner -- but at close to $86, Cerner is not nearly as attractive as it once was, especially when taking into account that 2011 may be the real big demand year for Cerner.

Still, Cerner may see demand pick up sooner than other IT companies, due to its focus on the large hospital market. Cerner's 1,200 hospitals are among the largest in the market and are expected to move more quickly on electronic records due to the time it will take them to implement the technology and train staff.

In the final analysis, however, the large hospital advantage doesn't translate into a long-term advantage for Cerner versus other IT players. Morgan Keegan's Stockton noted that of the $45 billion that the government expects to dole out for the electronic records initiative, the larger portion of $25 billion is slated for the physician practices. Allscripts is 85% physician-based, while AthenaHealth is exclusively focused on the physician market.